Procedure of Liquidity and Creditworthiness Analysis of the Company

It is necessary to study property status of the company when analyzing its liquidity and creditworthiness. Property status is an amount of enterprise assets and sources on their kinds. The range of factors, calculated according to the accounting reports, is used in the assessment of the enterprise property status. It is possible to make a conclusion on qualitative changes, structure of economic means, and their sources based on the factors of property status.

Factors, characterizing the property status, are calculated, their change for the year and for a series of years are defined at the property status analysis, based on the accounting balance-sheet. The data is the following:

1. Capital value of the company (Cap.) is the amount of economic means, being at the disposal of the enterprise. It is equal to the total accounting balance-sheet — net:

Cap. = F.No 1, balance total.

2. Equity capital(EC) is the equity funds of enterprise at the specified date, defined at the section 3 of balance «Capital and Reserves»:

EС= F.No 1, section 3.

3. Own circulating assets (OCA) refer to the value of net worth, which are in cycle. They are defined by adding of fixed liabilities (FL) to the equity capital (EC), and deduction of the fixed asset (FA) sum:

OCA= EC + FL — FA.

The same factor can be calculated as the difference between mobile (current) assets (CA) and current liabilities (CL):

OCA= CA — CL.

4. Functioning capital (FC) is the amount of own circulating assets, which take a constant part in circulation. As a rule, own circulating assets are in the overdue accounts receivable, they do not take part in circulation for a long time, and are immobilized (т.е. are not in circulation). Means, which are in debit indebtedness, and will be returned in 12 months after the reporting date, do not take part in the circulation. Therefore, in order to estimate the functioning capital, it is necessary to exclude the following factors from own circulating assets (OCA): debit indebtedness, which payments will be returned in 12 months after the reporting date (DI), and overdue accounts receivable (OAR), shown in form No 5:

FC=OCA-OAR-DI

5.Debt capital (DC) is an amount of long-term (LL) and current liabilities (CL). It characterizes the amount of enterprise indebtedness at this date and is equal to the total of summary parts 4 and 5 of accounting balance-sheet:

DC = LL + CL

6. Current assets (CA) or «Mobile Assets», «Turnover means» characterize means, being in reserves, cash outflow, and in debit indebtedness, i.e. total of part 2 of assets:

CA= total of part 2A

They are called mobile assets because they may be quicker, than other assets, contrary to capital assets and other noncurrent assets, returned as monetary funds for settlements with debtors.

7.Current assets(CA) or short-term obligations refer to indebtedness, which should be payed within a year. Short-term loans and credits refer to this indebtedness:

CA = F.No 1, total of section 5.

8. Fixed assets(FA), which are also called «immobilized assets», is a sum of capital assets and other noncurrent assets, which, contrary to current assets, (mobile assets) circulate more slowly and are defined according to the total of section 1 of assets, i.e. by the formula:

FA = F.No 1, total of section 1.

10. Fixed liabilities(FL) refer to credits and loans, obtained for the extended period over a year. They are shown in balance passive of section 4.

FL = F.No 1, total of section 4.

11. Production reserves and expenses(PRE) refer to current assets, being in production reserves and expenses:

12. Quick assets(QA) refer to means, which should be shortly directed for meeting current liabilities. Debit indebtedness, which payments are expected to be returned in 12 months after the reporting date, refer to quick assets:

QA= QA in12 m.

13. The most liquid assets(MLA) refer to all monetary funds and current financial investments.

MLA = MFI + Cur.Fin.Inv.

14. Sticky assets(St.A) refer to means, which are hard to use for meeting current indebtedness. Total fixed assets (Total of section 1 of assets and overdue accounts receivable) refer to slow assets:

St.A = FA + OAR

Creditworthiness is a possibility to timely repay own payments of obligations with available supplies. Creditworthiness assessment is carried out on the basis of liquidity characteristics of current assets, i.e. time, necessary for turning them into cash assets.

In turn, balance liquidity analysis consists in the comparison of means on assets, grouped on the degree of decreasing liquidity, with liabilities on passive, grouped on the degree of urgency of their repayment. Enterprise assets are divided into 4 groups depending on the degree of liquidity:

— A1) the most liquid;

— A2) quick;

— A3) slow;

— А4) sticky assets.

Passives are grouped on the degree of their payment urgency:

— P1) the most advance liabilities are credit indebtedness and delayed payments on loans;

— P2) current liabilities are current credits and loans;

— P3) fixed liabilities are fixed credits and loans;

— P4) constant liabilities — are shareholder’s equity of the company.

The relation between groups of assets and liabilities characterizes liquidity, i.e. the ability of the enterprise to pay for own current liabilities. The balance is considered as absolutely liquid if:

The relevance of accounting liquidity evaluation gets special emphasis in conditions of economical instability, as well as upon the liquidation of enterprise due to its bankruptcy. Here there is a problem: if the enterprise has enough means for meeting the indebtedness. The same problem emerges when it is necessary to define if the enterprise has enough funds for the settlements with debtors, i.e. ability to liquidate (repay) debts with funds available. In this particular case, liquidity means the presence of current assets in the enterprise in the theoretically sufficient amount for the repayment of current liabilities.

A whole system of factors, such as ratios, is calculated for the evaluation of enterprise accounting liquidity, which reflects the correlation of certain balance sheet items and related financial records.

We suppose that the company’s chief executive can esteem the company liquidity at the stage of exposure to the accounting balance-sheet, comparing the amounts of section 5 of liabilities «Current liabilities» with the amount of section 2 of assets «Current assets». Exceeding of current assets over the sum of floating liabilities shows that the enterprise has a potential to settle with creditors, however, current assets should considerably (more than twice) exceed current liabilities in order to consider the accounting balance-sheet of enterprise liquid. But for the overall estimation of liquidity and creditworthiness, relative figures are calculated for the beginning and ending of the analyzed year alongside with the absolute ones, as well as their dynamics for a year should be estimated and compared with the established standards. The factors are the following:

Current ratio gives the overall assessment of enterprise liquidity, characterizing how current liabilities are met by current means, i.e.. how many rubles of financial recourses, invested into current assets, fall within one ruble of current liabilities; and is calculated by division of the amount of current assets (total of section 2 of assets) by current liabilities (total of section 5 of passives), i.e. by the formula:

CR = CA / CL

As a rule, the increase of this factor is considered to be positive. However, a considerable increase of this factor is unfavorable and is indicative of slowing of the asset turn-over, invested into production reserves, unjustified growth of debit indebtedness. According to the enterprise work experience, it is considered to be normal, when this factor does not exceed 2.0. It may be considered as satisfactory if the value is within the limits of 1.5.

Quick Liquidity Ratio (QLR): characterizes the rate of monetary funds, processing operations and other assets in current liabilities and are calculated by the following formula:

QLR OCA= (MFI+ QA in12 m — OAR) / CL.

Quick liquidity ratio defines the ability of the enterprise to perform current liabilities from quick assets and complements the coverage ratio. Low rate of quick liquidity ratio is indicative of high financial risk and bad potential for the attraction of additional financial assets from the outside. This factor is normal when it does not exceed 1.0, i.e. when quick assets equal or exceed the amount of current liabilities. This factor is of interest for banks and other credit establishments at the credit arrangement.

Absolute liquidity ratio (ALR): characterizes the rate of monetary funds, current liabilities, and is defined as a ratio between monetary funds (the most liquid assets) and current liabilities. It is calculated by the formula:

ALR = MLA / CL.

Based on the absolute liquidity ratio, it is possible to estimate the monetary asset availability for covering of current liabilities. This factor is considered to be normal when it does not exceed 0.2. However, the increase of this factor is unfavorable, as the funds should be circulated, i.e. work and bring income. It is of primary interest for suppliers of goods and services of this enterprise. Its inaccessibility can be connected with fast-changing conditions of business and necessity of full involvement of all material resources in circulation, and primarily money means at first instance.

The aforementioned liquidity ratios are considered as basic, and it is possible to make a conclusion on their liquidity, the ability to meet payments, and creditworthiness of the enterprise. Besides, it is recommended to calculate the following factors for a deeper study of enterprise liquidity.

Functioning capital mobility or the ratio of functioning capitalmobility (RFCM), which is defined as a ratio between the amount of means in reserves and expenses and the functioning capital, i.e. own circulating assets minus overdue accounts receivable and is calculated by formula:

RFCM = Resrv.Expens./ FC

This factor characterizes the equity rate of the enterprise, which is in condition not allowing its free manipulation, because it is necessary to include reserves and expenses in circulation in order to settle with the creditors. According to the work experience in the industrial enterprises, this factor is normal when it does not exceed 0.5, i.e. the amount of resource and expenses does not exceed 50% of the total own circulating assets. The presence of high ratio of functioning capital flexibility increases the danger of bankruptcy, which is an indicator of immobilization of equity capital in the business inventories, which will not be realized soon, and their amount is directed for covering of short debts, and makes it difficult to repay for current liabilities.

Total capital flexibility or ratio of total capital flexibility (TCF) is defined as a ratio of current assets, i.e. current assets to the amount of economic means (capital) by formula:

TCF TCF= CA / Cap.

This ratio shows the rate of a more flexible capital in the total of economic assets, which can be quickly turned into monetary means contrary to immobilized (immobile) assets.

This factor is normal when it does not exceed 0.6, i.e. current assets in the total amount of economic means make over 60%. The higher is the ratio, the more liquid is the enterprise, and the quicker is a turnover of enterprise funds, and the higher is the efficiency of means usage.

We should further mention that at the credit investigation of the organization we compare means on the assets side of the balance sheet, grouped according to their liquidity rate, with liabilities on passive, and also grouped on the periods of repayment. Then ratios, characterizing the creditworthiness level of enterprise, are calculated.

Enterprises are grouped according to the liquidity rate, which is the rate of conversion in monetary assets. The groups are as follows: the most liquid assets, quick assets, slow assets, and sticky assets. Liabilities on the debt repayment ratio are divided as follows: the most advance liabilities, current liabilities, fixed liabilities, and constant liabilities.

Repayment ratio of the most advance liabilities(RR MAL) is defined as a ratio between the most liquid assets (MLA) and the sum of the most advance liabilities (SAL):

RR MAL. = MLA / SAL

Repayment ratio of the current liabilities(RR CL) is defined as a ratio between current assets (CA) and the sum of current liabilities (SCL): by the formula:

RR CL =CA/ SCL

Repayment ratio of the fixed liabilities(RR FL) is defined as a ratio between slow assets (SA) and the sum of fixed liabilities (SFL): by the formula:

RR FL= SA/SFL

Comparison of slow assets and fixed liabilities shows the prospective liquidity, i.e. prediction of creditworthiness on the basis of future cash proceeds and payments. Slow and sticky assets are usually used for the indebtedness coverage at the corporate bankruptcy.

The ratio of slow assets and constant liabilities should be below 100%, i.e. capitals and reserves of the enterprise must exceed fixed liabilities, otherwise OCA will be absent in the company.

Calculation of liquidity ratios and creditworthiness, carried out in such a manner, offers an opportunity to compare enterprise balance for various periods, as well as balances of various enterprises for the assessment of their financial soundness and solvency.

When analyzing creditworthiness of enterprises, it is necessary to consider causes of financial difficulties, frequency of their formation, and duration of outstanding debts. Causes of financial insolvency are noncompliance with a plan on production and realization of products; increase of its production cost; nonfulfillment of a profit plan, which is the deficiency of own self-financing sources; and high taxation ratio. One of the causes of financial solvency worsening is an improper use of a current capital: redeployment of funds into account receivable, investment into excessive inventories and other objectives, which temporarily have no financing sources.

Those enterprises, in which liquidity and financial solvency ratios are below the mark, and have a tendency to worsening, can be considered financially unstable. In order not to reduce the enterprise to such a level, it is necessary to carry out a systematic analysis and financial stability assessment, as well as liquidity and financial solvency of the organization. The improvement of business solvency level of the enterprise is achieved by:

— production expansion and realization of products;

— surplus reduction of unfinished and finished goods;

— reduction of receivables and payables and liquidation of defaulted debts;

— timely procession of own liabilities;

— increase of the working capital rate in current assets, turnover acceleration etc.

Moreover, carrying out the assessment and analysis of liquidity and creditworthiness at the specific enterprise, it is necessary to take into account its industrial, regional etc. specificity as far as possible.

Contrary to the accounting liquidity, which characterizes the ability of enterprise to repay to their current debtors at the moment, financial stability is a certain condition of enterprise, guarantees its constant financial solvency. This constant financial solvency can be reached by the achievement of good economic solvency.Economic solvency of the enterprise is how well the company can maintain financial sovereignty by means of the effective use of labor and material resources of the enterprise, production expansion and realization of output.

Investigating a financial accountability, the head of the enterprise can make a primary conclusion on the financial stability, comparing the total balance sheet section 3 «Capital and reserves» with the total section 4 «Fixed liabilities» and section 5 «Current liabilities», it is possible to make a primary conclusion on the financial stability. Exceeding of total balance sheet section 3 shows that the enterprise is financially stable, it is less dependent on external debts and creditors.

Then the head of an enterprise should compare total sections 2 «Current assets» and 5 «Current liabilities» of the accounting balance-sheet. Considerable exceeding of total section 2 of assets shows that proprietary funds prevail in current assets, which is also an indicator of financial independence of the enterprise from creditors, i.e. business solvency of the company.

The key figure of creditworthiness is equity ratio, financial soundness, and financial leverage.

Total debt to equity characterizes self-sufficiency of financial condition on the economic entity from the borrowed financing sources. It shows the rate of own funds in an aggregate amount of economic means and is computed using the following formula:

TDE = EC + Cap.

The growth of total debt to equity testifies on the increase of financial independence and decrease of financial difficulty risk. The value of this factor should be within 0.5 — 0.7, but not below 0.5.

Financial stability ratio is a relation between proper and borrowed assets. It is defined by the formula:

FSR = EC / DC.

Exceeding of proprietary funds over the borrowed ones means that the economic entity has a certain financial soundness and is relatively independent from external financial resources. This factor is normal when it is above 2.

Flexibility of equity capital is defined as a relation between functioning and equity capital and characterizes the rate of own circulating assets (minus the overdue accounts receivable) in own assets, and is defined by the formula:

FEC = FC / EC.

The value of this factor should be within 20 — 30%.

Leverage ratio gives evidence on the increase or decrease of financial leverage and risk of financial difficulty, characterizes the economic means which fall at 1 rouble of proprietary funds, and is defined as a ratio of economic means (capital) to the owned capital by the formula:

Lev. R. = Cap./ EC

This factor is reverse to total debt to equity. If its level is equal to one, this means that the owners fully finance their enterprise with the equity capital.

The rate of debt capital concentration characterizes the rate of attracted capital in the total of economic means. It is defined by the formula:

R cn. DC= DC / Cap.

The lower is the rate, the higher is the financial self-sufficiency and independence of the enterprise. The amount of total debt to equity and concentration of debt capital must be equal to 1.

Debt-equity ratio. The value of this factor can notably vary, depending on the capital structure, and industry classification of the enterprise. It is defined by the formula:

DER = DC / EC.

The lower is the rate, the higher is the financial self-sufficiency and independence of the enterprise, as well as the enterprise autonomy in front of external debt holders.

It is necessary to point out that there are not any regulatory criteria for the analyzed liquidity and creditworthiness ratios, as well as financial stability They depend on various factors: industry classification of the enterprise, working capital turnover, crediting principles, existing structure of financing sources, goodwill of business and other factors. Therefore, the acceptability of these ratio values, assessment of their dynamics and changing trends can be established only as a result of space-temporal comparison on the related enterprise groups.

One may formulate a single rule for the enterprises of any kind: company owners (stockholders, investors, and other persons, who made a contribution into the equity capital) prefer a smart growth in the leverage ratio dynamics; creditors (raw material suppliers, banks, providing short-term loans, and other counterparties), on the contrary, prefer enterprises with a high equity base, and bigger creditworthiness.

In such a manner, a complex analysis based on the system of liquidity and financial solvency ratios allows the economic entities thoroughly defining condition and demand in the monetary assets, and predict the financial strategy under the conditions of economic instability.

A principal task of liquidity and creditworthiness analysis of the enterprise is the bankruptcy assessment of the enterprise, or financial instability. Financial analysis allows detecting the threat of bankruptcy and timely conduct the system of measures on the financial enterprise recovery. There are certain formal and informal criteria, which make it possible to consider the enterprise insolvent.

Insolvency (bankruptcy), according to Article 2 of the law «On Insolvency (Bankruptcy)», dated October 26, 2002 No127-FZ, is the failure of the debtor to satisfy the demands of bond-creditors, and (or) carry out liabilities on mandatory payments. At the assessment of corporate bankruptcy probability, a technique named «Second Breath» is used. The following factors are calculated herewith:

1. Solvency Ratio:

SR = CA — OAR / CL.

If the solvency ratio is below 2, then the enterprise is considered to be insolvent.

2. Debt to Equity Ratio:

DER= EC / CL.

If this ratio is below 2, then the enterprise is also considered to be insolvent.

3. Equity to total assets:

ETA = EC + Cap.

If this ratio is below 0.5, then the enterprise is considered to be insolvent on this ratio.

4. Equity Ratio:

ER OCA= EC + Loan Equiv./ CA

If this ratio is below 0.1, then the enterprise is considered to be insolvent.

According to this technique, the decision of enterprise insolvency is taken if the sum of numeric value of failure parameters makes less than 4.6, i.e. the sum of numbers on all four failure ratios does not exceed 4.6.

Altman model is used in foreign practice at the liquidity and creditworthiness analysis, it defines the integral factor of bankruptcy threat. This model is called Altman ‘Z-score» in practice. This model is a weighted total ratio of financial indicators. The calculation is based on the five-factor model, which is a complex ratio factor, defining the value ratio of individual factors in the integral estimation of bankruptcy probability. Altman model has the following view:

Z-score= 1,2 X1 + 1,4 X2 + 3,3 X3 + 0,6 X4 + 1,0 X5

where Z-score is an integral factor of bankruptcy prediction level;

X1 is ratio between own circulating assets and the volume of assets;

X2 is ratio between undistributed profit and the volume of assets;

X2 is ratio between profit and the volume of assets;

X4 is a ratio ratio between equity capital and borrowed capital;

Х5 is asset turnover or the ratio between the revenues from sales and assets holdings.

The higher is Z-score value, the less is the likelihood of bankruptcy for two years. Based on Z-account of Altman, four levels of bankruptcy are distinguished:

1.Bankruptcy likelihood is very high when the Z-score value is below 1.80;

2.Bankruptcy likelihood is high when the Z-score value is between 1.81 and 2.70;

3.Bankruptcy likelihood is low when the Z-score value is between 2.70 and 2.99;

4.Bankruptcy likelihood is very low when the Z-score value is above 3.00.

Generally the degree evaluation of enterprise closeness to bankruptcy allows detecting the threat of bankruptcy and timely conduct the system of measures on the financial enterprise recovery.

Based of the analysis of obtained factors, it is possible not only to establish and evaluate enterprise liquidity and creditworthiness, but also to perform works on their enhancement. Liquidity and creditworthiness analysis shows the problems of the company, on which the work should be done, offers an opportunity to reveal primary aspects and the weakest points in financial condition of the enterprise and to work out measures on their liquidation. Liquidity and financial solvency analysis of the enterprise is a constituent of financial analysis, which is, in turn, a part of general, total analysis of economic activity.

It is necessary to perform the analysis of property status, liquidity and creditworthiness assessment, and the analysis of the enterprise on a regular basis, as well as the assessment and analysis of business solvency, and probability of corporate bankruptcy for timely prevention, revelation, and the elimination of negative variances of liquidity and creditworthiness ratio in the enterprise.